The Shadow Transfer Pricing Rules: Crediting Foreign Taxes

by K&L Gates LLP

At the end of the 2013, the IRS issued, in the form of a Chief Counsel Advice [1] (CCA 201349015), its view on the applicability of transfer pricing concepts to transactions involving disregarded entities (“DEs”) in the context of crediting foreign taxes. While advisors have long suspected that the IRS would continue to press “non-compulsory” foreign tax credit arguments, the release of the CCA brings to the forefront an issue that many taxpayers would have preferred to continue to view as an uncomfortable nuisance.

Section 482 of the Code [2] and the regulations thereunder generally require that transactions between commonly controlled parties reflect or contain terms similar to those of taxpayers dealing at arm’s length with an uncontrolled or unrelated third party. Since transactions between a foreign branch or DE and its owner generally do not have effect (or are disregarded) for U.S. tax purposes, transfer pricing, at least superficially, is not always given much consideration. [3] However, given that the U.S. provides for a mechanism for the crediting of foreign taxes, the U.S. does not want to simply cede its taxing jurisdiction or amount of tax collected to a foreign country. Since Section 482 is generally not applicable to disregarded transactions, the “non-compulsory payment” rules provide a method by which to apply transfer pricing principles to disregarded transactions.

Under the non-compulsory payment rules (and related Code sections), [4] a foreign tax is not considered paid if the amount exceeds the amount of the liability under foreign law.  Under applicable Treasury regulations, the amount of taxable income must be computed in accordance with a reasonable interpretation of foreign tax law and applicable treaties. Moreover, a taxpayer must substantiate that its or its DE’s foreign tax return was prepared in accordance with a reasonable interpretation and application of foreign tax law (as modified by applicable treaties) in such a way as to reduce over time, its reasonably expected tax liability under applicable foreign law.  Further, the taxpayer must show that it had exhausted all effective and practicable remedies, including competent authority procedures, to reduce its tax liability. [5] Thus, according to the IRS, U.S. transfer pricing rules may be relevant in determining whether non-arm’s length terms have produced or resulted in non-compulsory payments of foreign tax.

Although the focus of the CCA is stated to cover transactions (i) between a U.S. corporation and its foreign DE or foreign branch and (2) between a U.S. corporation and an affiliated U.S. corporation’s foreign DE or foreign branch, the CCA also discusses transactions involving foreign DEs and foreign branches of controlled foreign corporations due to the potential availability of indirect foreign tax credits under Section 902. [6] Thus, taxpayers should consider the transfer pricing/non-compulsory payment concepts whenever a foreign tax may be creditable.

For some, relief from complex and costly U.S. transfer pricing compliance was a consideration when structuring their offshore operations as branches or DEs, especially U.S. pass-through entities and taxpayers who were just starting to dip their toes in the offshore marketplace. Although such concerns are still valid to a certain extent, going forward, taxpayers must be more mindful of the terms underlying transactions with DEs. Although this development is not completely unexpected, it is just one more issue that taxpayer’s must consider in structuring transactions and engaging in business in other jurisdictions around the world.

Practice Pointers

  • Taxpayers must be more mindful of transactions with DEs or branches to ensure that the non-compulsory foreign tax payments rules are dealt with satisfactorily, including taking into account transfer pricing principles.
  • Taxpayers must carefully consider the proper level of documentation to satisfy compliance with arm’s length principles as it relates to non-compulsory foreign tax credit payments. Taxpayers can expect the IRS to assert that the taxpayer has the burden of proof in such situations.
  • Purchasers of foreign business (where a Section 338(g) is not made) must be attentive to these rules with respect to the historic attributes of their targets and thus purchasers have one more important item to add to their due diligence check list.

Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code of 1986, as amended or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within.

[1] A CCA is written advice or instruction, under whatever name or designation, prepared by any National Office component of the Office of Chief Counsel that (a) is issued to Field or Service Center employees of the Service or Field employees of the Office of Chief Counsel, and
(b) conveys any legal interpretation of a revenue provision, any Service or Office of Chief Counsel position or policy concerning a revenue provision, or any legal interpretation of State law, foreign law, or other Federal law relating to the assessment or collection of any liability under a revenue provision. See Section 6110(i)(1) of the Code.

[2] For purposes hereof, the “Code” refers to the Internal Revenue Code of 1986 as amended.  Unless otherwise indicated all section references are to the Code and the Treasury regulations promulgated thereunder.

[3] For example, with respect to a U.S. owner that has a foreign branch or DE, as long as there was some comfort that the foreign branch was earning, at a minimum, sufficient returns in the local jurisdiction, complex transfer pricing analysis and documentation was avoided.

[4] See Treas. Reg. Section 1.901-2(e)(5) and Section 905(b).

[5] Thankfully, these rules do not compel wasteful or futile efforts, but rather contain more of a reasonableness/practicable standard. 

[6] Although the CCA notes that it is not addressing U.S. branches of foreign corporations, the CCA goes on to list and described potential issues involved with such structures.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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